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p. 55 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Central Asia The Pacific Cook Islands Fiji Islands Kiribati Republic of the Marshall Islands Federated States of Micronesia Nauru Papua New Guinea Samoa Solomon Islands Democratic Republic of Timor-Leste Tonga Tuvalu Vanuatu III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia

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Vanuatu

The economy continued to suffer from recession in 2002 but modest recovery is projected over the medium term. The relatively high cost structure remains a factor in restraining growth, and competitiveness of the tourism industry has declined in recent years with the appreciation of the real exchange rate. Consequently, renewed efforts are needed to implement the Comprehensive Reform Program and to pursue further structural reforms so as to improve the economy's competitive position.

Macroeconomic Assessment

GDP fell further in 2002, by 0.3%, following a contraction of 2.7% in 2001 (Figure 2.35), reflecting the effects on agriculture and tourism of several major cyclones and weak demand. Agriculture as a whole strengthened modestly but the forestry subsector contracted by 34% following a similar drop in 2001. The cocoa subsector exhibited depressed conditions, though copra production grew by 7.1%, boosted by subsidized prices and, despite the cyclones, generally good weather conditions.

The construction sector expanded by 5%, stimulated by government expenditures on upgrading the airports on Efate and Santo, while the services sector as a whole contracted by 0.9%, with the hotels and restaurants subsector and government services leading the decline. Total visitors in 2002 were 7.4% lower than a year earlier, attributable to a decline in tourist arrivals due to a combination of greater competition from other destinations in the Pacific and, to a lesser extent, a relatively high real exchange rate.

Inflation moderated to around 2.0% in 2002, from 3.5% in 2001. Exports grew by 7.0% in 2002, following a steep fall in 2001; imports rose by 2.9%, following weak growth in 2001. The current account deficit narrowed slightly to 2.0% of GDP. Gross official reserves were slightly lower than in 2001 but still sufficient to cover around 6 months of imports of goods and services.

The Government's fiscal position improved in 2002, with an overall deficit of 2.1% of GDP, following 2 years of more sizable deficits. The improvement was mainly due to expenditure restraint and, in particular, to the impact of financial controls on personnel costs. A tight cash situation persisted in 2002 with the Government still using a system of monthly warrants to control spending. Revenues were also lower than originally estimated, reflecting the impact of weaker than expected economic growth. However, the impact of improvements in VAT and customs administration was also evident in 2002. Several privatizations that had been planned for 2002 (including Air Vanuatu, National Bank of Vanuatu [NBV], and Telecom Vanuatu) were delayed.

In mid-2001, the Government instructed the Vanuatu Commodities Marketing Board to pay substantial copra subsidies that had to be financed by direct advances from the Reserve Bank of Vanuatu (RBV). The price subsidy has continued and was estimated at about 1% of GDP in 2002. Supplementary budget support was also provided to the Asset Management Unit (AMU), amounting to about 0.9% of GDP in 2002. This was to repay the NBV for NPLs that had been transferred to the AMU.

Overall public debt declined slightly from 38.0% to 37.0% of GDP in 2002. Around three quarters of it is external debt on concessional terms. The funding of substantial losses at the National Provident Fund contributed to a significant buildup of domestic debt in 1997-1998 but the Government currently has a cautious approach to borrowing. External debt service costs are relatively low but the main government focus is on total debt service requirements relative to government revenues, which stood at 6.2% in 2002, or below the target limit of 7.0%.

The money supply declined by 1.7% in 2002, largely reflecting a significant decline in net foreign assets. Domestic liquidity conditions eased for most of the year with currency and deposits increasing by 44.7%. Total domestic credit grew by 11.9%, driven primarily by strong credit growth for the Government, which itself was mainly in the form of a very large increase in the overdraft with RBV. Private sector credit expanded by around 7.9%. In 2002, commercial deposit interest rates eased slightly while commercial lending rates rose on average, and as a result, the average spread widened to 12.0% from 11.3% in 2001 and 10.1% in 2000. The effective spread is, however, considerably larger than this due to the common requirement for significant deposits as collateral, which are often financed by additional borrowing. Tight foreign exchange restrictions from early 2000 also contributed to the wider interest rate margins. Between mid-2001 and mid-2002, the vatu depreciated against the Australian dollar by 2.3% and against the euro by 6.8%, but appreciated against the US dollar by 8.1%.

The OECD designated Vanuatu as an uncooperative tax haven in April 2002, along with a handful of other jurisdictions. However, Vanuatu has taken steps to stay off the Financial Action Task Force list of uncooperative countries on money laundering. There have been concerns about the enforcement capacity of anti-money laundering regulations, but positive steps were taken in 2002. The introduction of "know-your-customer" guidelines in mid-2002 is expected to improve the effectiveness of anti-money laundering measures. A new International Banking Act was passed in November 2002, which will put offshore banks under the supervision of RBV from this year. Proposals are also being developed for more effective supervision in the nonbank offshore sector. Increasing global concerns about money laundering may have prompted recent actions; however, there is still much resistance and divided opinion in the offshore business community.

Policy Developments

Vanuatu is characterized by numerous long-standing structural weaknesses that raise costs relative to those of competitors, by fiscal limitations, and by vulnerability to external shocks and political developments. The Government has been implementing a Comprehensive Reform Program since 1998 to improve governance, particularly in the areas of parliamentary, judicial, and legal procedures, public sector efficiency, and financial management. Despite reasonably good progress, much more remains to be done.

Government expenditures on the wage bill, as a share of the total, continues to be relatively high, despite efforts made under the Comprehensive Reform Program to reduce them. The Government has recognized the need to strengthen the fiscal position through a broadening of the tax base, and a Revenue Strategy Committee has identified options to do this, though progress has been slow due to resistance from business. The need remains, however, to improve compliance with present taxes, and the Government's intention is to lift the ratio of taxes to GDP from the current 22-23% to 27%.

The prospective introduction of PICTA would place pressure on Vanuatu to establish new revenue sources, as it is still highly dependent on tariff revenues, despite the introduction of VAT in 1998. Tariff revenues constituted 35% of total revenues (including grants) in 2002 and are projected still to be 33% of total revenues in 2005. In 2002, the average implicit tariff was 24%. Under PICTA, all tariffs would have to be gradually removed by 2016. The impact would also be intensified once tariffs on products from Australia and New Zealand are reduced under the Pacific Agreement on Closer Economic Relations.

The 2003 budget announced an increase in import duty rates by 5 percentage points for various imported foods, medicines, insecticides, and textiles and an increase in the existing tariff from 20% to 40% for various timbers, from 30% to 40% for certain fruit juices, and from 25% to 40% for canned meat. As PICTA has not yet been ratified, there is no contradiction with the Agreement but some of these tariff increases are likely to entail adverse economic efficiency effects, which could be avoided by the use of excise taxes.

It has long been recognized that Vanuatu has a high cost structure relative to neighboring and competitor countries. For example, compared with the Fiji Islands, electricity tariffs are twice as high, the retail price of gasoline is 40% higher, and local telephone calls are three times as high. Internal and international transport costs are also much higher than in neighboring countries.

Part of the explanation for this relates to the geographic dispersion of the population across several well-separated islands and to the lack of appropriate regulatory arrangements for local monopolies. In addition, the heavy reliance on tariffs means that import duties on business inputs directly raise the cost of production. While a duty drawback scheme is in place, it does not extend to all business inputs or all businesses. The exchange rate also seems to undermine competitiveness: the real effective exchange rate has appreciated by nearly 10% over the last 6 years.

Outlook for 2003-2004

Modest economic recovery is forecast in the medium term with growth of 1.3% in 2003 and 2.2% in 2004. These growth rates are lower than the current population growth rate of around 2.6%, implying a decline in per capita income. Inflation is projected to continue to be moderate, at 2.5% in 2003 and 2004.

Agriculture is expected to lead the recovery. Tourism is also expected to pick up with the recent completion of two new hotels and ongoing advertising campaigns. A switch in the focus of the tourism market from certain other Asian locations as a result of security concerns, to the South Pacific and the flow-on effects of sporting events in this part of the world, will help support tourism in Vanuatu in 2003, but the cost aspect remains a consideration. The government sector is projected to decline in real terms by 5-5.7% in the medium term, contributing to relatively weak overall economic growth but helping secure a more sustainable fiscal position and facilitating longer-term private sector development.

The 2003 budget forecasts a modest overall surplus of 0.4% of GDP, which is projected to increase marginally in 2004. Much of the surplus will be realized from a reduction in development expenditures. The wage bill is projected to remain approximately constant in nominal terms but decline modestly as a share of total recurrent spending and relative to GDP in the medium term. However, this depends on the Government meeting the projected targets for these expenses.

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